TARIFFS, TAXES AND ELECTRONIC COMMERCE: REVENUE IMPLICATIONS FOR DEVELOPING COUNTRIES

Transcription

1 UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT POLICY ISSUES IN INTERNATIONAL TRADE AND COMMODITIES STUDY SERIES No. 5 TARIFFS, TAXES AND ELECTRONIC COMMERCE: REVENUE IMPLICATIONS FOR DEVELOPING COUNTRIES by Susanne Teltscher UNCTAD Palais des Nations 1211 Geneva 10, Switzerland susan.teltscher@unctad.org UNITED NATIONS New York and Geneva, 2000

2 NOTE The views expressed in this study are those of the author and do not necessarily reflect the views of the United Nations. The designations employed and the presentation of the material do not imply the expression of any opinion whatsoever on the part of the United Nations Secretariat concerning the legal status of any country, territory, city or area, or of its authorities, or concerning the delimitation of its frontiers or boundaries. Material in this publication may be freely quoted or reprinted, but acknowledgement is requested, together with a reference to the document number. A copy of the publication containing the quotation or reprint should be sent to the UNCTAD secretariat: Chief Trade Analysis Branch Division on International Trade in Goods and Services, and Commodities United Nations Conference on Trade and Development Palais des Nations CH 1211 Geneva UNCTAD/ITCD/TAB/5 UNITED NATIONS PUBLICATION Sales No. E.00.II.D.36 ISBN ISSN Copyright 8 United Nations 2000 All rights reserved ii

3 ABSTRACT Cross-border electronic commerce is currently operating in a tax- and tariff-free environment. This, combined with predictions of steep increases of e-commerce during the next five years, has prompted Governments and tax authorities to discuss modifications to existing legislation that take account of these developments. One of their concerns is the potential loss in tax and tariff revenues resulting from e-commerce, which account for significant shares of government budgets in most countries. This is of particular concern to developing countries, where import duties comprise higher shares of government revenue and a shift to other revenue sources is economically less feasible. The paper presents data on potential revenue losses from import duties on a number of products that have been traded physically in the past but are increasingly being imported digitally. Findings show that developing countries will be the main losers as far as import duties from e-commerce products are concerned, while both developing and developed countries would suffer major revenue cuts from lost consumption taxes. iii

4 ACKNOWLEDGEMENTS I am very grateful to Hiroaki Kuwahara for his contribution to the tariff and trade data analysis, and to Florence Cuenod Guenin for her assistance in collecting the import duty data. Bijit Bora, Erich Supper and Christopher Stevens provided useful comments on earlier versions of the paper. iv

5 CONTENTS ABSTRACT...iii Introduction...1 I. Import tariffs and Classification of E-commerce...3 A. Conceptual issues...3 B. Regulatory issues...6 II. III. IV. E-commerce Taxation...8 A. Consumption taxes...9 B. Income taxes...12 C. A need for global coordination...14 Trade and Tariff Revenues on Digitizable Products...16 A. World trade in digitizable products Exports of digitizable products Imports of digitizable products...18 B. Tariff rates on digitizable goods...18 C. Tariff revenues...19 D. Implications of the Information Technology Agreement...20 Additional Import Duties and Taxes...21 A. Types of additional duties and taxes...21 B. Calculation of additional duties...21 C. Amount of additional duties...22 D. Revenues from customs duties and taxes...22 V. Conclusions...24 VI. References...27 ANNEX 1: FIGURES...31 ANNEX 2: TABLES...37 v

6 INTRODUCTION The most debated topic in electronic commerce at the present time, both among policy makers and the business community, is whether and how to collect tariffs and taxes on cross-border electronic commerce (e-commerce). So far, no national or international legislation has been put in place. At the same time, a steep increase in e-commerce during the next decade is predicted: the Organisation for Economic Co-operation and Development (OECD) estimates that it may reach a value of US$ 330 billion by and US$ 1 trillion by (OECD, 1999b). According to Forrester Research estimates, business-to-business e- commerce accounted for US$ 150 billion in This is expected to reach over US$ 3 trillion by 2004 (The Economist, 2000b). Hence, there is legitimate concern by Governments, especially in the developing countries, over the potential erosion of their tax base resulting from e-commerce if domestic and international rules are not modified to take account of these developments. Data on government finance statistics support this concern (Table 1 and Figure 1). They show that taxes are the principal source of government revenue, accounting on average for about 80 per cent of total revenue (all countries). Domestic taxation of goods and services makes up the largest share in tax revenues (36.5 per cent). 1 Revenues from import duties account on average for 13.2 per cent of total revenue and 17.5 per cent of tax revenue. Major differences exist between developing and developed countries: for the former, import duties as a share of total government revenue are 15.8 per cent (compared with 2.6 per cent for developed countries) and as a share of tax revenue 21.2 per cent (compared with 3 per cent for developed countries). 2 The combined tax revenues 1 Mainly sales and value added taxes. 2 In the case of the European Union, individual member countries do not report revenues from import from goods and services and those from imports account for 54 per cent of tax revenues (all countries), or 58.3 per cent of developing countries and 37 per cent of developed countries tax revenue. Hence, they make up a major source of government revenue in most countries. 3 How will these revenues be affected by e- commerce? Will the increase in digital trade substantially reduce revenues from import duties and taxation of domestic goods and services? Should e- commerce therefore be subject to border tariffs and taxes? The question of whether to levy tariffs on crossborder e-commerce has been taken up by the World Trade Organization (WTO). In 1998, WTO member States agreed to a two-year customs duties moratorium on electronic transmissions. A decision on whether to extend the moratorium should have been taken at the Third WTO Ministerial Meeting 4 but has been postponed. The broader subject of Internet taxation has been taken up by other forums. A number of proposals are currently being prepared by the OECD, the European Union and the United States for harmonizing taxation rules on international e- commerce and thus prevent potential fiscal losses that could result from a rapidly growing number of duties (some report very low values). This is because EU import duties are directly passed on to the EU common budget as a traditional own resources payment, and only 10 per cent is retained by the importing country (this share will be increased to 25 per cent as of 2001). Therefore, the calculations of EU member States import revenues are based on their individual contributions to the EU budget (European Commission, 1998). 3 Other important sources not considered here are income taxes and social security contributions. 4 The Third WTO Ministerial Meeting was held in Seattle from 30 November to 1 December

7 international on-line suppliers, whose cross-border transactions will be subject to import and domestic taxes. (section V). On this basis, possible revenue losses resulting from e-commerce, particularly in the developing countries, are shown. Developing countries are largely left out of these debates. Within the WTO, they have raised concerns about possible tariff revenue implications resulting from a ban on customs duties on electronic transmissions. However, they lack resources to provide evidence which could support their concerns. Many of them are still struggling to keep up with the rapid developments in the area of e- commerce, recognizing that it has the potential for substantial beneficial effects on their economies. 5 The taxation debate is very much dominated by the OECD countries, which have little concern for developing countries interests, given the latter s small share in e-commerce. However, developing countries could be much more affected by fiscal losses resulting from e-commerce in view of their greater dependence on tariffs and taxes as revenue sources for their national budgets. This paper attempts to bring the developing countries concerns into the debate on potential revenue implications of e-commerce by looking at both tariff and tax revenues. Section II provides a short overview of the discussion on border tariffs for e-commerce taking place in the WTO. Key to this debate are conceptual and regulatory aspects of imposing customs duties on electronic transmissions. Section III looks at Internet taxation issues such as consumption and income taxation. Section four moves to the empirical part of the paper. It first analyses, using trade and tariff revenue data, the potential economic impact if in fact digitizable products replace physically delivered goods. Particular attention is paid to the impact on developing countries. This is followed by an analysis of additional duties levied on imports (besides border tariffs), including domestic consumption taxes 5 For a discussion on e-commerce and development, see ITU (1999). 2

8 I. IMPORT TARIFFS AND CLASSIFICATION OF E-COMMERCE The Geneva Ministerial Declaration of May 1998 includes for the first time in GATT/WTO history a mandate for work in the area of e- commerce. It specifies two elements: first, a standstill agreement on the imposition of customs duties on electronic transmissions; and second, a General Council mandate to establish a work programme on global electronic commerce. Four WTO bodies (the Council for Trade in Services, the Council for Trade in Goods, the Council for Trade- Related Aspects of Intellectual Property Rights and the Committee for Trade and Development) were thus instructed to examine and report on different aspects of e-commerce. 6 Although member States decided that all aspects concerning the imposition of customs duties on e-commerce would be examined in the General Council, the four WTO bodies had to address customs duties when discussing the classification of e-commerce, or more specifically, of electronic transmissions. Classification broadly refers to the question of whether electronic transmissions, or products shipped electronically (instead of physically), should be characterized as goods, services, intellectual property or something else. It is thus an issue that cuts across the debates in all four bodies. So far, no agreement has been reached. In fact, the difficulty of finding an agreement on the classification question has held up progress in the work on e-commerce, especially in the Council for Trade in Goods. The link between the classification issue and the ban on customs duties is simple: depending on how electronic transmissions are defined, different multilateral agreements apply. For example, if they were classified as goods, they would be subject to General Agreement on Tariffs and Trade (GATT) rules, which would make electronically shipped products dutiable. If they were classified as services, on the other hand, they would be subject to General Agreement on Trade in Services (GATS) rules, and the application of customs duties would be questionable. This, in turn, would have different implications for government revenues obtained from tariffs imposed on these goods. Several WTO member States have therefore suggested that a final decision on the extension of the customs ban be delayed until the classification issue has been solved. The following will take a closer look at the conceptual and regulatory issues related to the classification of e-commerce (and hence the imposition of border tariffs), and how existing multilateral rules address them. 6 Since 1998, each body has held a number of meetings where Members discussed and made proposals on the issues relevant to the work programme. By the end of July 1999, each body had submitted a progress report to the General Council. These reports have been reviewed by the General Council and were to be used for submitting recommendations to the Seattle Ministerial Conference for decision. The Seattle Conference, however, did not address the subject of e-commerce and a decision has been postponed until negotiations restart in Geneva. At the General Council meeting of 17 July 2000 Members decided that the four WTO bodies should continue their work on e- commerce, including the identification of cross-sectoral issues. They will report back to the General Council in December The question of the extension of the customs ban has been put aside. 3 A. Conceptual issues In the Geneva Ministerial Declaration, Ministers also declare that Members will continue their current practice of not imposing customs duties on electronic transmissions. In order to fully understand the meaning and implications of this decision, the terms customs duties and electronic transmissions deserve further consideration. The decision on the ban on customs duties is based on a proposal submitted by the United States in February 1998 to the General Council, noting that currently, no Member of the WTO considers

9 electronic transmissions as importations for customs duties purposes and, thus, not one imposes customs duties on them (WTO, 1998). Therefore, according to the United States, WTO Members should agree to continue this current practice so that the absence of customs duties on electronic transmissions would remain. Thus, the proposal, first, suggests that electronic transmissions are not considered as importations by countries; and, second, implies indirectly that electronic transmissions could theoretically be considered as importations in the sense of GATT Article II. They would therefore be subject to tariffs. This contradiction is at the heart of the debate at WTO: on the one hand, it is not clear whether electronic transmissions should be regarded as an importation of goods and therefore fall under the GATT; on the other hand, the term customs duties suggests that an importation is actually taking place. Customs duties in the traditional GATT/WTO sense imply the importation of a good, which could then be subject to border tariffs (GATT, 1986). The World Customs Organization (WCO) Harmonized System of Classification and Description of Goods (HS) codes are applied to these importations at the international level. Imports that cannot be classified under the HS coding system (e.g. services) are not subject to border tariffs. Customs duties on imports do not normally include domestic taxes on goods or services; rather, these remain a domain of national policy. On the other hand, most countries levy some additional duties and taxes on imported goods. These include excise taxes, value-added taxes, consumption taxes and other fees, some of which are being equivalent to taxes charged on domestically produced and sold goods (and services). Hence, it is necessary to define clearly the term customs duties : does it merely refer to most-favoured-nation border tariffs (the GATT meaning) or does it also refer to additional customs duties and taxes imposed on imports? In the latter case, the discussion would clearly move into the area of domestic taxation. This is why some people have confused the issue of whether electronic transmissions should be subject to domestic taxes with the proposed ban on customs duties. 7 Section IV will discuss and provide empirical evidence on additional customs duties levied on imports. A second important element in any further discussion at the WTO is the definition of electronic transmissions, i.e. whether the digits transmitted over the Internet should be classified as goods, services, or something else. For certain electronic transactions, an agreement could be reached fairly easily. For example, goods that have been ordered, paid for or marketed electronically but shipped physically are clearly goods in the traditional sense and all relevant agreements (such as the GATT) would apply. Similarly, the supply of (traditional) services via electronic means would clearly fall under the GATS. They include financial services, accountancy, tourism, computer-related and backoffice services, educational and, of course, telecommunications services. The most controversial debate concerns the electronic transmission of data which have physical counterparts, e.g. books, music, film and video material, and software (WTO, 1999b, 1999d, 1999e). In the past, these products were shipped physically via carrier media such as CDs, diskettes and tapes. They were physically moved across borders, where they were subject to import duties. Today, and increasingly so in the future, they are being sent via data files through virtual networks, thereby crossing numerous (sometimes unknown) borders. The data are then downloaded onto a carrier medium, printed or stored on a computer. They could be sent to individuals for direct consumption or to retailers for distribution. How should these data or their content be classified? Are they equivalent to a hard copy of a book or catalogue, a CD or videotape and therefore 7 See, for example, Wall Street Journal, Europe, 7 October

10 to be classified as a good? Is the transmission of the data itself a service and should the data thus fall under the services category? Or should there be a third category of electronic transmissions, some mixture of goods and services? But, in that case, which would be the governing multilateral rules? The following raises a number of issues that should be taken into consideration when deciding on a possible classification of electronic transmissions: According to the traditional WTO definition, a good would be a trade where the end product can be converted into a tangible or physical product; a service would be an end product that is intangible, i.e. it cannot be converted into a physical good. However, given that electronic products can be stored in electronic or intangible form, some WTO Members have suggested that there could be a new category of intangible goods ; here the GATT would apply, as opposed to intangible services, where the GATS would apply. The criteria for these intangible goods remain to be defined. Clarification is needed on whether downloaded data could fall under the definition of an import (WTO, 1999c). This is important since the GATT and customs duties apply only in the case of an importation. Is there something that actually moves across borders, in the sense of an importation according to Article II of the GATT? Are the data carried by a carrier medium (e.g. a CD) also an importation or only the carrier itself? Currently, these data are subject to import duties if they are imported via a carrier medium (which is still the case for the large majority of media and software products). Should a distinction be made between the mass distribution of electronically transmitted goods and personalized distribution? For example, if a commercial catalogue is sent electronically to a publisher overseas where it will be printed and distributed, should it not be subject to customs duties like its physical counterpart? On the other 5 hand, if an individual buyer requests and receives advertising material on a specific product from the manufacturer, should this not be defined as a service? In the former, the GATT would apply, in the latter the GATS would apply. Rather than being a good, could not the content of the digital transmission be intellectual property? For example, in the case of software, the value is not the actual product but rather the licensing fee paid to the manufacturer. This relates to the question of to what extent the HS system can be applied to electronic transmissions. So far, the HS identifies the relevant products together with the carrying media, and not separately. Should there be HS codes for intangible goods? 8 One useful suggestion has been to define electronic transmissions as goods if they (a) can be locally stored and (b) are transferable (Drake and Nicolaidis, 1999). 9 Locally stored here refers to the possibility of downloading the product onto a physical media, even if it does not have a tangible form (i.e. if it is downloaded onto a computer). Transferable refers to the possibility of preserving the value of the product independently of the initial consumer and transferring it to another consumer without the intervention of the producer. These two criteria would clearly distinguish electronic goods from services and may be better suited than traditional criteria, such as inclusion in the HS commodity 8 It should be noted that the HS coding system includes a heading for electrical energy (27.16), clearly an intangible good. However, the use of this heading is optional, i.e. it is left to the discretion of the HS Contracting Parties. Because of the disagreement among WCO member States on the question of software, the WCO decided not to introduce three new HS codes to classify software in its 2002 revision of the HS system, as had been originally foreseen. 9 This definition is similar to that of goods and services made by Hill (1977).

11 system, tangible or intangible character of the good, etc. Three points clearly emerge from the above discussion. First, the classification issue requires moving beyond traditional definitions in order to account for new technologies that have transformed the original concept of goods and services. Second, it would be oversimplistic to define all electronic transmissions as services, given the obvious likeness between, for example, an article or a movie downloaded from the Internet and a journal or videotape bought at a store. Finally, no matter how these products will eventually be defined, a number of them, which currently form part of customs schedules and are thus subject to import tariffs, will be likely to fall under different import regulations in the future. The question of potential revenue losses thus remains valid in all cases. B. Regulatory issues Within the WTO context, there are also important political and regulatory implications associated with the electronic delivery of goods and services. Depending on the classification, the trade is subject to different multilateral rules: goods are subject to the GATT, the Agreement on Technical Barriers to Trade, the Agreement on Customs Valuations, or rules of origin; while services are subject to the GATS. The underlying differences between agreements and the resulting implications for domestic policies have been the main factors in countries favouring specific proposals. For example, the European Communities has proposed that all electronic transmissions be classified as services (WTO 1999a), 10 which would be subject to the GATS. This would (among other things) allow the 10 This corresponds to an EU proposal on Internet taxation, which suggests that, for consumption tax purposes, trade in digitized goods should be treated as a supply of services (European Commission, 1999, 2000). EU to restrict the imports of audio-visual services (including television programmes and movies). The United States, on the other hand, leans towards a goods classification or GATT approach, arguing that this could provide for a more trade liberalizing outcome for electronic commerce (WTO, 1999f). A similar controversy between the United States and the EU is taking place in the discussion on Internet taxation (see section III). In general, the multilateral rules for services are still far less elaborate than the multilateral rules for trade in goods, providing countries with substantially more leeway for national policy discretion in the services trade. One important difference between the GATT and the GATS relates to general obligations. While the GATT s general obligations include mostfavoured-nation treatment (MFN), national treatment and a general prohibition on quantitative restrictions, the GATS includes the national treatment principle only in negotiated specific commitments and specific services. For example, WTO member countries have defined in their national schedules whether, for a certain services trade, foreign suppliers will be given national treatment, i.e. whether they are subject to the same rules as domestic suppliers of the equivalent service. In other words, if a country grants national treatment, and if the WTO Members decide to include electronic transmissions in the GATS framework, no additional taxes can be imposed on foreign suppliers by that country. If no national treatment is specified, on the other hand, imports could be subject to higher taxes than domestically supplied services. A second important difference between the GATS and the GATT is the possibility of imposing quantitative restrictions or quotas. While the GATT (in general) prohibits the use of quotas, they are allowed under the GATS (depending on the market access commitment specified in a country s schedule). Theoretically, therefore, this could mean that a country could put (in principle) a limit on, say, 6

12 the number of books transmitted electronically via the Internet. 11 The question therefore remains, to what extent are e-commerce-related services covered by individual countries national schedules? It would be important for countries to review their schedules with respect to the supply of electronic services before the next round of services negotiations. In particular, developing countries should identify those services sectors where they have a comparative advantage in the export of electronic services. It becomes clear from the above discussion that the classification question has wide implications for the electronic trade of goods and services and therefore for the organization of production and distribution, which relate directly to the underlying rules of the existing multilateral agreements. Border tariffs are one of the problems to be addressed, especially given their potential impact on government revenue. Should electronic transmissions be defined as services and thus tariff-exempted, fiscal losses would occur. In addition, most imported goods are subject to domestic taxation, which in the case of services is usually lower or non-existing. Should these goods now be imported electronically and be tax-exempted because they are classified as services, further revenue losses would occur. The following section moves to the debate on taxation and e-commerce and looks at how tax revenues may be affected by e-commerce. 11 Although it is not clear how this could be enforced, it is a question that has to be solved in the discussions on how to include e-commerce in the WTO agreements. 7

13 II. E-COMMERCE TAXATION Contrary to the debate on customs duties, where a number of countries have advocated a tariff-free environment, nobody has so far proposed that e-commerce be made tax-free. Rather, it should be tax-neutral or subject to the same taxation as conventional commerce. Furthermore, the taxation debate clearly moves beyond goods or digitized products and includes traditional services, which are subject to consumption taxes in many countries. The main players in the debate on e-commerce taxation have been the United States, the EU and the OECD. 12 The United States and the EU member States are primarily concerned with how their respective tax systems will be affected by e- commerce. 13 The OECD secretariat, whose Model 12 Business as well as government institutions have participated in these debates and made proposals on how to handle Internet-related tax questions. While business interests are less of a concern in this paper, it should be noted that they mainly relate to avoiding double taxation and to simplifying indirect taxation that arises from inconsistencies among definitions, classification, source of supply rules for services, registration requirements, reverse charges, collection etc. For further discussion, see Global Information Infrastructure Commission (GIIC) website at 13 In 1998, the United States Congress created the Advisory Commission on Electronic Commerce under the Internet Tax Freedom Act, to study a variety of issues involving e-commerce taxation, including international issues. The Commission is collecting proposals from the public and private sectors for consideration, which will contribute to the final report and recommendations it will provide to Congress no later than April At its final meeting in March 2000 (Dallas, Texas), the Commission voted, among others, to extend a three-year moratorium on domestic new Internet taxation imposed by the Internet Tax Freedom Act and due to expire at the end of However, no solutions have yet been provided on the question of state and local tax collection, a major concern to local governments. Within the EU, various bodies have addressed and prepared background documents on Internet taxation (e.g. the EU s Taxation Policy Group, the EC Directorate-General on Taxation and Customs Union). Tax Convention serves as a basis for most bilateral tax treaties (including between non-oecd member countries), has been asked by its member States to take the international leadership role on e-commerce and taxation, a mandate that was confirmed at the 1998 OECD Ministerial Meeting in Ottawa. It has prepared a number of taxation principles that should govern e-commerce and has worked closely with the EU on consumption tax issues. Developing countries have participated little in these debates and the proposals and papers so far produced by the OECD countries have given little consideration to developing countries concerns. 14 While it is true that developing countries shares in e-commerce are still modest, the international rules and regulations that are adopted now will impact on e-commerce in many countries in the future, including in the developing countries. In addition, the increasing number of small and medium-sized enterprises (SMEs) that will be drawn in by e- commerce from the developing countries have little experience in international taxation issues. It is therefore crucial to include their concerns as early as possible. This section will briefly introduce two key issues currently debated as regards Internet taxation (besides customs tariffs): consumption taxes and income taxes. It will present proposals that have been put forward on how to change existing tax regulation in the light of e-commerce and discuss possible implications for developing countries. 14 An earlier OECD proposal on basic principles of international e-commerce taxation made reference to developing countries, stating that any tax arrangements adopted domestically and any changes to existing international tax principles should be structured to ensure a fair sharing of the Internet tax base between countries, particularly important as regards division of the tax base between developed and developing countries (Owen, 1997). However, this principle was not included in the final set of basic principles agreed upon in 1998 (OECD, 1998a). 8

14 A. Consumption taxes The erosion of the consumption tax base resulting from e-commerce has caused considerable concern among Governments, given the steep growth of e-commerce in the past years and predictions for the next five years. Consumption taxes usually include value-added taxes, sales taxes and turnover taxes. Traditionally, they are borne by the consumer and collected by the seller; different rules apply depending on the product or service sold, the location of consumer and seller, and the type of consumer (business or individual). With e-commerce, the number of foreign on-line suppliers, who are often subject to different taxation rules, has increased considerably. Research carried out in the United States on the impact of taxation on Internet commerce and consumer on-line purchasing patterns found that consumers living in high sales tax areas are significantly more likely to buy on-line than those living in low sales tax areas (Goolsbee, 1999). Hence, differentiated Internet taxation rules among countries could have a significant impact on consumers purchasing behaviour, shifting from domestic to foreign suppliers. 15 This raises several problems for tax authorities. First, it leads to the gradual elimination of intermediaries (so-called disintermediation) such as wholesalers or local retailers, who in the past have been critical for identifying taxpayers, especially private consumers. Second, foreign suppliers may be tax-exempted, whereas local suppliers are normally required to charge value added tax (VAT) or sales taxes. Third, direct orders from foreign suppliers could substantially increase the number of low-value shipments of physical goods to individual customers. 15 Although there are also barriers that could prevent this shift, such as other regulatory obstacles (besides taxation), delivery problems, or cultural and linguistic barriers. To circumvent these, some United States suppliers have started to buy local competitors in Europe (The Economist, 2000b). These low-value packages now fall under so-called de minimis relief from customs duties and taxes in many countries, basically to balance the cost of collection and the amount of tax due. A substantial increase in these shipments as a result of e- commerce (where foreign suppliers replace domestic ones) could pose an additional challenge to tax as well as customs authorities. Major differences exist between the EU and the United States in the way taxes are redeemed and hence in their approaches to international taxation rules on e-commerce. The EU countries derive a large proportion of government tax revenue from taxes on domestic goods and services (mainly VAT) (29 per cent, see Table 1). In addition, VAT extra charges contribute 45 per cent to the EU Community budget (in addition to customs duties and GNP contributions). 16 Their main concern is the increasing import of digital content and services from outside the EU, which would be exempted from VAT payments in the EU. The United States Government, on the other hand, derives most of its tax revenues from personal and corporate income tax and social security contributions; revenues from taxes on domestic goods and services are extremely low (3.6 per cent). 17 The United States is currently both a net exporter and the main exporter of e-commerce worldwide. Hence, it has a great interest in encouraging business (including e-commerce business) to locate in the United States and pay direct taxes to United States tax authorities. 16 The 45 per cent contribution in 1997 (the date of Table 1) was reduced to 35 per cent in 1999 (projection) (European Commission, 1998). 17 Within the United States, individual states and local governments have autonomy over determining and collecting state and local sales tax, often their biggest source of revenue. Sales taxes differ substantially among states, ranging from 0 to 7 per cent. United States-based on-line suppliers selling to out-of-state (including foreign) customers do currently not have to charge local sales tax. States are therefore becoming increasingly worried about how to secure their sales tax revenues in the light of Internet commerce. 9

15 Therefore, the issue of consumption taxes has received most attention in the OECD and the EU. In particular, the EU feels very strongly about maintaining VAT duties and is likely to modify tax rules in a way that will ensure a continuation of VAT contributions, rather than lowering or eliminating them. A closer look at current VAT regulations in the EU will explain the growing concern among EU tax authorities and Governments. 18 Goods. Imported goods from non-eu members are subject to (import duties and) VAT of the importing country. Sales within the EU are subject to the VAT of the receiving country in the case of business-to-consumer trade. Businesses selling to businesses in another member State are tax-exempted; the receiving or importing business is required to pay VAT locally (i.e. in the country of final consumption). 19 Exports to non-eu countries are zero-rated. Services. Services differ according to the type of services traded. In the case of information (currently the majority of e-services), imports from non-eu businesses to EU consumers are not subject to customs duties and are VAT-exempted (except for Denmark, France and Italy). Sales from non-eu businesses to EU businesses are subject to selfaccounted VAT at the local rate (a so-called reverse charge). Intra-EU service suppliers are required to charge VAT in the country in which they are established (location of the seller), if selling to private consumers. EU-business-to-business services trade is subject to VAT in the country of the final consumer. Sales to customers outside the EU are subject to VAT in the location of the seller 18 For details and facts on EU VAT rules, see European Commission (1997). The complexity of the existing EU VAT system is considered by business a major barrier to developing e-commerce in Europe. 19 This regulation was put in place in 1993 under the transitional VAT arrangements, with the objective of removing border controls for tax purposes inside the European Community. (European Commission, 1999; Kerrigan, 1999). The challenges to EU tax authorities that arise from e-commerce therefore lie in non-eu supplies of e-services to EU customers (and in an increase in non-eu customers not subject to EU VAT). Under current tax law, these are exempted from VAT, while at the same time their share is increasing, in direct competition with EU suppliers who are subject to VAT payments. Furthermore, the VAT exemption provides incentives for suppliers to locate outside the EU, a fairly easy undertaking in e- commerce, which no longer requires the presence of human and technical resources. A number of suggestions have been made on how to modify and harmonize VAT legislation in order to accommodate e-commerce. The OECD has come up with framework conditions on consumption taxes, recommending that (OECD, 1998a): The taxation of cross-border trade should be in the jurisdiction where the consumption takes place; The supply of digitized products should not be treated as a supply of goods for consumption tax purposes (differences in the definition among countries may lead to uncertainties about the tax treatment of products from outside suppliers); Where services and intangible property (i.e. goods) from suppliers outside the country are acquired, countries should examine the use of reverse charge, self-assessment or other equivalent mechanisms; Appropriate systems should be developed to collect tax on the importation of physical goods. The first two recommendations deserve further consideration. Since it is unlikely that non-eu sellers will collect taxes from their EU customers for EU tax authorities (or any foreign supplier for another country s tax authorities), it seems reasonable to 10

16 move VAT collection to the place of consumption, away from the location of the seller. 20 Here, a key problem for tax authorities will be to identify the customer and the location of the jurisdiction responsible for collecting the tax. Because of the process of disintermediation, apart from the seller and the customer there are no other parties involved in the transactions (which could collect the tax). Credit card companies, Internet service providers (ISPs), banking and payment systems providers or telecommunications companies have been mentioned as potential new intermediaries in verifying the location of a customer and the respective tax jurisdiction. This, of course, raises privacy issues and possible abuses of information. It could also lead to an increasing use of foreign credit cards or digital cash; needless to say, the customer s location may differ from the billing address. In addition, how can an Internet seller determine whether the customer is a business or an individual consumer, each of which is subject to different VAT rules? An increasing number of e-commerce businesses are small entrepreneurs operating from home who may receive services for business or personal purposes. The OECD proposal to treat digitized products as services corresponds to an EU proposal that for VAT purposes trade in digital goods be treated as a supply of services. The EU also proposes that VAT rates on all e-services be harmonized into a single rate. This could result in tax losses since consumption taxes are lower on services than on goods. It could also lead to losses on tariffs and import duties on digital goods that were shipped physically in the past and which would now be 20 The EU has proposed that non-eu suppliers selling in the EU be required to apply taxes on the same basis as an EU operator when transacting business in the EU. In order to facilitate compliance, they propose that non-eu e- commerce operators be required to register in one EU member State and have the possibility of discharging all their obligations by dealing with a single tax administration (European Commission, 2000). subject to much lower duties. This would impact in particular on the developing countries, whose reliance on import duties as a government revenue source is much higher than in the developed countries (Table 1). Data on potential revenue losses, if digitized products were exempted from import duties and taxes, are presented in the next section. At the Ottawa Conference, the United States took a different position on this issue: digital products should be characterized on the basis of the rights transferred in each particular case. It argued that some goods which are now zero-rated (such as books or newspapers) would be subject to VAT if treated as a service. Customers may therefore prefer to buy local zero-rated books rather than digitally imported (and taxed) services, many of which could be supplied by United States on-line providers. As an alternative, the United States has proposed an origin-based consumption tax for intangibles (e-services), which would be collected from the supplier and not from the consumer. It argues that it is easier to identify the supplier than the customer on the basis of permanent establishment rule (see below) and since businesses are subject to audit. The United States as a net exporter of e- commerce would benefit from an origin-based tax, while it may further erode the tax base in e- commerce-importing countries. On the other hand, it disadvantages domestic producers in their export sales since they would have to pay the tax on the exports, instead of the final consumer. This may encourage business to set up shop in countries with no origin-based taxation. Finally, one needs to keep in mind that most e-commerce will be business-tobusiness (currently 80 per cent of e-commerce), which is often tax-exempted or subject to voluntary compliance Recent predictions give business-to-consumer e- commerce steep growth rates as well. According to Forrester Research, business-to-consumer e-commerce in 11

17 How does consumption tax legislation affect developing countries? Most of them rely heavily on consumption taxes for their government budgets (Table 1). Given that many developing countries will be net importers of e-commerce in the medium term, they would have a strong interest in not eroding their tax bases by switching to an origin-based tax system. They need to be aware, however, that tax collection on e-commerce activities will require access to the latest technologies by tax authorities. Thus, developing countries need to catch up on modernizing their tax administration systems in order not to lose important tax revenues on the collection of consumption taxes. To avoid double taxation, some multi- or bilateral agreements have to be adopted on where consumption taxes are to be collected: in the country where the supplier is established, the country where the customer is established or the country of consumption. A proposal by the EU to require non- EU suppliers to register for and charge VAT in a EU country would not favour providers from developing countries, thus placing an additional burden on their e-commerce exports. B. Income taxes The taxation of income, profits and capital gains is another major source of government revenue, especially in the developed countries. There are two basic concepts of how countries tax income. First, source-based taxation is applied in the jurisdiction where the economic activity takes place, for example the sale of the service or digital good traded. Foreigners who do not reside in the jurisdiction where their economic activity takes place are still taxed on their profits earned in that jurisdiction. the United States accounted for US$ 20 billion in 1999, and is expected to reach US$ 184 billion by Goldman- Sachs estimates that electronic shopping could account for per cent by 2010 (The Economist, 2000b). Second, residence-based taxation takes place in the jurisdiction of place of residence of the person/business earning the income. In other words, taxpayers are taxed on their worldwide income by the country in which they live. Among the OECD countries, it is agreed that if a permanent establishment has been determined, source-based taxation applies; if not, residence-based tax principles apply (Lukas, 1999). The usual practice among OECD countries is to tax residents on their worldwide income and non-residents on the income they earn in the relevant country. 22 To avoid double taxation, countries enter into bilateral treaties, for example to reduce or eliminate source tax. Treaties are normally based on the OECD Model Tax Convention, which defines residence-based taxation according to where the management takes place. If no treaty exists, domestic tax legislation governs the taxation of non-resident businesses carrying on business in the country. In this case, the source principles generally apply. Traditionally, direct taxation of income has used the permanent establishment principle used in the OECD Model Tax Convention (Article 5) to determine in which country income has been generated and is therefore taxed. Accordingly, business profits of non-resident enterprises may only be taxed in a country to the extent that they are attributable to a permanent establishment that the enterprise has in that country, which must also be a fixed place of business. However, the principle was drafted in 1963 and is not fully compatible with e-commerce as it relies on physical presence. For example, the source-based concept of income taxation could lead to a substantial erosion of the tax base since the link between income-generating 22 The United States is again a different case: United States citizens are subject to taxation on their total global income in the United States, no matter whether they are resident in the United States or in another country. United States taxation law allows them, however, to offset the taxes paid in their country of residence against their United States tax liability. 12

18 activity and a specific location becomes blurred in e- commerce. In particular, the question of whether a website or web server can constitute a permanent establishment or fixed place of business has been at the centre of the debate. The OECD has therefore proposed the following amendments to Article 5, which would be applied to e-commerce (OECD, 2000): An Internet website does not constitute a place of business, as there is no facility such as premises or, in certain circumstances, machinery or equipment. On the other hand, the server operating the website is a piece of equipment which needs a physical location and may thus constitute a fixed place of business of the enterprise that operates it. A distinction between the enterprise that operates the server and the enterprise that carries on business through the website is necessary. If the website is hosted by an Internet Service Provider (ISP) and a different enterprise carries on business through the website, the server cannot be considered a fixed place of business. The server and its location are not at the disposal of the enterprise and the enterprise does not have a physical presence in that place since the website does not involve tangible assets. A server constitutes a fixed place of business if it is located in a certain place for a sufficient period of time. In the case of ISPs, even though they own and operate the servers (i.e. fixed place of business), they cannot be considered to constitute permanent establishments of the businesses whose websites they host, because they will not have the authority to conclude contracts in the name of the enterprises they host and thus are not agents of those enterprises. Whether computer equipment used for e- 13 commerce operations may be considered permanent establishment needs to be examined on a case-by-case basis, depending on whether the equipment is used for activities that form an essential part of the commercial activity of an enterprise (as opposed to being used for merely preparatory or auxiliary activities). In this case, and if the equipment constitutes a fixed place of business, it would be a permanent establishment of the enterprise. 23 What would be possible implications for tax revenues if these amendments to Article 5 were implemented? For example, if a web server would constitute a permanent establishment of a business, and since little resources are needed to set up and maintain a server, it could encourage the migration of servers and computer equipment to low-tax countries, including some of the developing countries. Currently, the United States has the highest concentration of web servers in the world; 24 should these be considered permanent establishments and thus be subject to direct taxation, the United States may take a minimalist position on income tax to prevent servers from migrating across the border. One problem that needs to be addressed is tracing the legal entity operating a business through a website and identifying the business and its physical location. Because of the difficulties in defining permanent establishment (and because of its large tax base), the United States has favoured residence-based taxation over source-based taxation. However, residencebased taxation may not favour developing countries, given their small number of residents with e- businesses. In the short run, they are primarily net e- commerce importing countries; hence, they would 23 OECD member countries have not yet agreed on what core functions of an enterprise could be. 24 According to The Economist (2000b), the United States currently accounts for 90 per cent of commercial websites.

19 have an interest in source-based rather than residence-based taxation. Also, a move to residence-based taxation may shift tax revenues from developing to developed countries once developing countries share as consumers of e-commerce increases. On the other hand, residence-based taxation favours tax havens, often developing countries. Here, developing countries could be attractive to foreign investors looking for certain, low-skilled activities in the production of digital content. If Article 5 is not amended, countries that are net importers of technology may face significant revenue losses because businesses may close down branches and replace them with Internet communications and e-commerce, which would not be regarded as permanent establishments and would thus be tax-free. Hence, the main business activity would not take place in the country any more, and the country s source-based tax would decrease. C. A need for global coordination No matter what changes to existing tax legislation are adopted, without a certain degree of international cooperation and harmonization of existing tax rules, the expansion of e-commerce will be hampered. Traditionally, tax collection has been based on the belief that individual countries have the right to set their own tax rules and little international cooperation and few multilateral agreements have been put in place. Unless this approach changes and countries agree to enter into multilateral tax agreements, tax competition will intensify with e- commerce. This is a likely scenario given that, even within the OECD, individual countries implement domestic tax rules that give them a competitive edge. 25 This is also why it is unlikely that countries 25 And even within the EU, VAT differs among member states. will collect taxes for other countries, for example in the case of VAT, where it has been suggested that VAT be collected from the country of the supplier (The Economist, 2000b). On the other hand, if rules are not harmonized internationally, the risk of double taxation may keep foreign suppliers/competition out; and non-taxation may distort competition against local suppliers. With a few exceptions, developing countries will not be part of an OECD agreement on Internet taxation. Nevertheless, they can use the principles and rules agreed upon as a basis for adjusting their own legislation. For example, developing countries have used tax legislation in the past to attract private foreign direct investment (FDI). Multinationals increasingly operate in countries that have low taxes or are willing to negotiate favourable tax regimes to attract foreign business (The Economist, 2000b). In fact, fiscal incentives are the most widely used type of FDI incentives (UNCTAD, 1996). Depending on the agreements adopted in the OECD, developing countries could negotiate specific bilateral treaties for e-commerce taxation, which would give them a competitive edge. For example, the transaction costs of setting up or moving a web server are low; hence, e-commerce allows companies to respond quickly to tax incentives by Governments and move their web servers to a developing country. Any decisions which developing countries may take on modifying their tax legislation to accommodate e-commerce, however, will have to take into account the significant role of tax and tariff revenues in their national budgets. Until new international agreements on e-commerce taxation have been defined, an increasing number of goods and services will be traded on-line, largely tax-free. This will have an effect on government revenue, especially if the goods and services have been subject to import duties in the past. In order to capture some of these (potential) revenue losses, the following section will analyze data on trade, tariffs and other import duties for a number of goods that are already supplied on-line or are likely to be so in 14

20 the near future. 15